Profits for Chinese-listed companies plunged 25.8% in the first quarter, compared with the same time last year, according to J.P. Morgan data posted Tuesday. Earnings for state-owned enterprises managed by the central government plummeted 41.8%.

The steel and shipping sectors fared the worst, posting record losses that are likely to deepen in the second quarter. In contrast, refiners and power generators are better poised for recovery, benefiting from lower coal and crude prices.

The overall steep falls in profit were an improvement from the fourth quarter of last year, due to a recent boom in bank lending, uptick in manufacturing orders and ‘bottoming out’ of exports. “State-owned companies have been the primary beneficiaries of the surge in new lending and stand to gain the most from the government’s fiscal stimulus program, given their dominance in the construction and materials industries,” said Jing Ulrich, China managing director at J.P. Morgan.

Still, with the recent rally in Chinese equities, investors are being too optimistic, some analysts say. In the face of a global demand slump and depressed prices, Chinese industry would be cutting capacity if it were acting economically rational.

But with Beijing’s priority of protecting jobs, China’s state-owned, industrial sector is prolonging its earnings slump in the long term by maintaining production — now overproduction — which contributes to depressed prices. Chinese domestic consumption will still take at least a couple of years to reach its potential and poses a “medium term challenge,” UBS economist Tao Wang has noted (See “China’s Other Worry: Wage Slowdown“).

“Capacity reduction is the unavoidable path to recovery, in our view. However, rather than seeing capacity retrenchment and business failures, we are seeing booming loans and reviving production,” Morgan Stanley strategists said in an April report. That creates a “job-rich” but “profit-deficient” environment, and investors are thus likely to see a stock retreat in the second half of this year.

“GDP growth is not all that’s needed for equities to perform,” they noted. “Equities trade on earnings and expectations.” They compared the current rally to 1998, when GDP growth, driven by government policies, was high, but profits collapsed.

Top Chinese aluminum producer, state-owned
Chinalco
, for instance, has been reluctant to cut output, due to the political sensitivity of layoffs, even though the market has an over-capacity problem, according to Cherry Chen of Core Pacific-Yamaichi International. That points to depressed aluminum prices for the rest of the year for the global market.